by W. Matthew Bryant
This was published as an article called, “Extended Warranties in Bonded Contracts: Effects on Bond Obligations, Costs and Negotiating Tips” in the ABA Forum on Construction’s November 2016 newsletter, Insurance, Surety & Liens. Mr. Bryant co-authored it with Ciara C. Young of Kinsley Construction, Inc.
Extended warranty periods are becoming increasingly common in construction contracts. Contractors can no longer assume the customary one year warranty or repair/maintenance period. The frequency of 18 month, two year and even five year warranties is growing. So, what does this mean and how does it impact the construction contract and any performance bonding obligations?
From bid time, the contractor must be aware of the warranty requirements of the bid documents. On bonded projects, the duration of the warranty period can substantially impact the bid price and contract sum. Most performance bonds guarantee performance of all obligations under the contract. The AIA A312 Performance Bond form provides as follows: “The Contractor and Surety, jointly and severally, bind themselves, their heirs, executors, administrators, successors and assigns to the Owner for the performance of the Construction Contract, which is incorporated herein by reference.” Other proprietary bonds are even more unequivocal and expressly state that the surety is obligated for all extended warranties.
Where a performance bond incorporates the underlying construction contract by reference, the provisions of the contract become provisions of the bond. For example, in Tudor Development Group, Inc. v. U.S. Fidelity & Guar. Co., 692 F. Supp. 461 (U.S.D.C. — M.D. Pa. 1988), the court held that where a plaintiff owner alleged that a contractor violated a warranty provision contained in the construction contract, the surety could be held responsible under the terms of the bond it supplied for the construction contract. Id. at 465. See also Sweetwater Apartments, 5 P.A., LLC v. Ware Construction Services, Inc., 2012 WL 3155564 at *5 (U.S.D.C. – M.D. Ala. 2012) (collecting cases). Similarly, when a contract including a warranty provision of 18 months, two years, or five years is incorporated into a performance bond, the surety guarantees performance of the contract obligation for the full contract warranty term. The surety’s obligation normally remains limited by the penal sum of the bond.
Typically, bond premiums are based on the bond remaining in place for one year from substantial completion. However, if the bond needs to stay in place for two years or more to cover extended warranties, the bond premium will increase accordingly. Sureties know that the longer the contractor’s obligations extend, the more risk the contractor and the sureties are taking on.
Unfortunately, contractors often just assume a one year period and fail to ensure the bond pricing used on bid day or in a negotiated contract covers the applicable warranty period for the project. If an extended warranty and the associated additional premium is missed in a hard bid or a negotiated contract, a contractor can find itself in the difficult predicament of either absorbing the costs, or going back to the owner and telling it that the bond costs will actually be much more, and asking it to cover the costs.
Contractors can use this knowledge to be creative in the negotiation process with owners in an effort to be the low bid and win the work. One option is to provide alternate pricing at bid time. For example, if the contract documents require a two year warranty, it may be beneficial to provide alternate pricing for a one year warranty. Also, in contrast to extended-term performance bonds priced on the full contract sum, owners may be willing to consider separate maintenance bonds that are typically based on only 10% of the contract sum as the repair or correction of a portion of the work is expected to be less than the cost of performing the whole of the contract work. This could be a value engineering option presented to an owner desiring the protection of extended warranties.
Also, if the contractor has subcontractor default insurance, it might be able to persuade an owner to not require performance bonds for more than the typical one year, thereby allowing the contractor to provide a savings to the owner that its competitors may not be able to provide. With subcontractor default insurance, a contractor can assure the owner that coverage exists to allow the contractor to address any deficiencies of the subcontractors’ work, and that performance bonds for the duration of the warranties are not necessary.
Owners are seeking longer warranty coverage for the work they ask contractors to perform. Contractors will provide the warranties their customers demand. Sureties will provide performance bonds that cover the contracts presented to them, at a price. Being aware of the implications of a warranty beyond the customary one year duration will allow owners, contractors, and sureties to consider the amount of assurance appropriate to guarantee performance of extended warranty obligations. The assurance needed can then be priced consistently with the risk undertaken by a surety, and all the parties can reach an efficient balance of risk and cost for a guarantee of extended warranty performance.
W. Matthew Bryant is a partner in the Chicago office of Arnstein & Lehr LLP. Mr. Bryant focuses his practice on construction and commercial litigation and dispute resolution. He has represented owners, architects, engineers, contractors, and subcontractors in lawsuits relating to construction defects, mechanics liens, bond claims, delay claims, change order disputes and fraud. To contact Mr. Bryant, please email firstname.lastname@example.org.